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In 2017, venture capital reached over $84 billion of investment in the United States alone.That's the most investment we've seen in decades. The question becomes: Is this increase in venture capital resulting in an increase in valuations (i.e., supply side), or are risks decreasing (and thus valuations rising), therefore requiring a higher venture capital investment to buy in?

Over the past five years, median pre-money valuation for seed rounds increased from $5 million to $7 million.The increase in median pre-money valuation is even more pronounced when analyzing series A round and B round valuations: Between 2013 and 2018, the median A round valuation more than doubled, from $9 million to $20 million. B round valuation nearly doubled, from $31 million to $60 million. Valuations are on the rise.

But the question is: Why?

My company has been performing valuation services for private companies since 2011. We've helped over 2,400 companies, ranging from $500,000 in capital raised up to pre-IPO, so we've seen our fair share of ups and downs. We set out to examine three possible reasons for the current rise of valuations. (The data for this analysis was obtained from 4,000-plus data points from Pitchbook between 2013-2018).

1. More Valuable Companies

The most straightforward explanation for why valuations have risen is that the risk of failure is lower, and thus private companies are actually worth more.

Why would startup companies suddenly become more valuable across the board? Some have pointed to technological infrastructure offerings like Amazon Web Services and GitHub that allow founders to greatly reduce startup or overhead costs.

Another hypothesis for the increase in valuations is that companies are learning faster between financing rounds and/or spending more time between financing rounds. Perhaps operating for an additional year between financing rounds lets companies build more value before revisiting their fundraising efforts?

We looked at the relative increase in median pre-money value from seed to A-round and noticed that regardless of time between financing, the pre-money valuation increased by about three times. More years between seed-round and A-round funding does not seem to boost the relative valuation increase between the two rounds.

Valuation of a company is the inverse of risk and has some correlation with the expectation of return. So, one reason why valuations have gone up would be that the risk of failure went down. If that were true, we should see a decline in failure rates for companies funding over the past five years. This seems like a plausible explanation, but it will be a few more years before we have enough data to evaluate it (and VCs and founders bury their dead very quietly, so it's hard to know for sure).

2. Reclassification

When comparing seed round (or A-round) valuations of companies between 2013 and 2018, we see a steady increase. But that's not as straightforward as it seems.

While you might presume companies always raise capital in a sequential manner (seed → A → B), in actuality investors can basically call anything a seed round, A-round or B-round. One company might raise four seed rounds in a row, while another company might raise a “pre-seed” round (that is actually what a series seed used to be), and one may raise a large friends-and-family round and then go straight to a Series A Round. There's no standardization, and consequently not all “seed rounds” are created equal.

The very first round of financing is now being funded by VC funds and not just angel investors. This makes a difference because the average angel-funded seed round is in the $250,000 range, while the average VC-funded seed round is often well over ten times that. “Seed” rounds now frequently take the place of what used to be series A-rounds. In other words, even if initial VC investment in companies remained constant between 2013 and now, we'd be seeing a huge jump in “seed round” funding.

3. Cascading Valuation

The third possible explanation for skyrocketing valuations is that we’re seeing a cascading effect for later valuations following high seed rounds.

A founder taking seed round money must raise a higher A round to fuel growth, and even more B round to fuel further growth. This falls apart if a round of investment fails to materialize. This especially becomes problematic when early investors offload shares in later rounds (thus why some have referred to the startup financing game as a Ponzi Scheme).

As we assess the data, we see a cascading effect in play, where there is a large jump in pre-money valuation between each round across the board, as founders use higher late-round proceeds to fuel growth and/or to “take money off the table” and/or pay off investors in earlier rounds.

Final Takeaways

So, which of these three reasons is responsible for valuations continuing to rise? The most probable answer is: All of them.

Startups are absolutely taking advantage of the improved software development infrastructure that's available today and can do things with Amazon Web Services, GitHub, HubSpot, etc. that make them more valuable. Reclassification has certainly occurred and is skewing perceptions of rising valuations to some degree. And signs of cascading valuation are present, which is an excellent reason to view startup investments in 2018 with caution. There's no guarantee that this will end up being a Ponzi Scheme -- but there's also no guarantee that it won't.

Overall, the best strategy is to avoid thinking about valuations and focus on solving problems you can't stop thinking about with people you enjoy spending time with.

Young Entrepreneur Council (YEC) is an invitation-only, fee-based organization comprised of the world's most successful entrepreneurs 45 and younger. YEC members…

Young Entrepreneur Council (YEC) is an invitation-only, fee-based organization comprised of the world's most successful entrepreneurs 45 and younger. YEC members represent nearly every industry, generate billions of dollars in revenue each year and have created tens of thousands of jobs. Learn more at yec.co. Questions about an article? Email feedback@yec.co.